Three Realities About Venture Capital

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This week’s kerfuffle over Yo centered on many facets, but none got more attention than the nascent startup’s $1.2 million in venture capital funding.

The reaction to this investment across the web came in several flavors. Founders complained that their own startups created far more value for society than an app that essentially acts as a doorbell, and yet, they had not received any venture capital funding. Another strain of incredulity focused on the investors themselves, who must have either been stupid or crazy to invest in such a “useless” product.

These reactions are all fair, and I can certainly understand some of the vitriol that emanated from the web this week. Unfortunately, a large number of the complaints seemed to be based on misinformation about the venture capital industry. This lack of understanding seems to have only magnified with the increasing numbers of marketers employed by VC firms.

I want to step through some of the realities of venture capital today, and hopefully shine light on the confusion that plagues its understanding. Specifically, I want to walk through the size of the VC industry, how limited partners affect the strategy of a firm, and the performance aspects of VC investing.

Reality #1: Venture Capital is a Small Star in the Massive Galaxy of Capital

But constraining ourselves to private equity would be a mistake as well, which itself is a relatively small asset class (although one that has grown tremendously over the years). Just this past month in May, conventional mutual funds had net inflows of $30 billion in capital, or almost double what venture capital funds raised in all of 2013. And that’s just for mutual funds, and doesn’t include massive asset classes like ETFs, bond funds, or just investors directly buying equities.

Investors looking to put their money to work have a dizzying array of options, and all asset classes must compete for those dollars. Investors share a variety of goals, including performance, risk, and diversification. Venture capital is a single star amid the entire Milky Way of capital, and it is truly a rounding error of the total wealth of the world, or even the wealth that is managed by investment firms.

Startup founders rarely ask about LPs when they are fundraising, but they really should.

One effect that this size has on the industry is that a sudden increase in popularity for venture capital can dramatically change the nature of the business. In the first quarter of 2014, venture funds raised about $8.9 billion in new capital, or double the amount of the same quarter last year. Twenty-five new funds were created as well, up from ten a year ago, again according to Thomson Reuters. That means we may be seeing a lot of people get into the venture capital business who have never invested in startups before.

Reality #2: Venture Capital is Weird, and thus, so are the Limited Partners

Venture capital is very unusual in the universe of possible asset classes. Unlike equities, where liquidity generally comes immediately or within a couple of days for block trades, venture capital dollars may be locked up for almost a decade. Once a limited partner invests in a VC fund, it is very unusual to get out of the agreement or sell the shares off to another LP. Angel investors and other early investors used to be able to sell their shares more freely on sites like SecondMarket, but with companies clamping down on that practice, most angels are increasingly expected to hold for the entire duration or sell at artificially low prices.

Venture firms, like most private equity firms, raise funds through private placements, in which a small number of investors offer capital to be managed. After the fundraise, no new capital can be added to a fund (which is why we say a fund has to reach its closing). Unlike an ETF, which can expand or contract elastically with demand, venture firms are raised once and spent over a period of years, typically five years of active investment with an additional five years for monitoring and management. This means that funds tend to be raised in good years and not in bad years, even though a saner strategy would probably have it the other way around so startups can exit in the most auspicious markets.

These dynamics drastically limit the universe of potential limited partners, the people who designate venture capitalists as managers of their money. There are very few groups involved in venture capital, since its long lock-up, illiquidity, irregular fundraising, and obtuse performance (to be discussed shortly) make it difficult for most investors to get involved. This is part of the excitement of new platforms like AngelList Syndicates, which might allow others to get involved in these sorts of investments.

Money for venture capital in the United States comes from four primary sources: endowments (particularly those at universities or research funding bodies), pension and insurance funds, corporations, and family offices.

Many of these investors are interested in venture capital because of its innovation and economic growth prospects. State pension funds, for instance, often invest in venture capital as a way to point out their investment in their state’s own economic growth, allowing it to navigate local politics more effectively. Similarly, university endowments like the connection between educating innovators in the classroom and financing innovation through venture capital.

For those endowments and wealth managers that can get their dollars into the right funds, the returns speak for themselves. For everyone else, it certainly appears as though they are wasting their time and money.

VCs and LPs negotiate a limited partner agreement that stipulates how management of the funds should work. I don’t want to dive into the details, but the key point here is that LPs are empowered to push their managers in particular investment directions. After all, it is their money that the venture capitalist is investing, and if they aren’t happy, the fund manager will eventually be looking for new work. Most of the power here is held by LPs through future fundraising though, rather than actual control of the funds.

Startup founders rarely ask about LPs when they are fundraising, but they really should. Some firms can make bets in spaces like clean tech and biotechnology because they have LPs who agree with that investment strategy and are willing to take on the risk in the hopes that their capital helps to improve society. Other VCs are deeply constrained by their LPs in the kind of investments they can do, and how risky those investments can be. Getting a sense of the flexibility here between the VC partners and their LPs can be quite helpful.

As an aside, this is one reason why Silicon Valley VCs are such a breath of fresh air for founders who have pitched to international VCs from their home countries. LPs in China, for instance, are much more likely to be sovereign wealth funds and companies rather than university endowments. The same is true in much of Asia. Many sovereign wealth funds and companies are ill-equipped to understand the kind of disruptive innovation that permeates Silicon Valley, if only because their experience may come from areas like construction and infrastructure rather than high-velocity technology startups. As one friend put it to me recently, many VCs are looking for venture-style returns with the low risk of a bank loan.

In short, LPs are a bit like destiny. They don’t determine the exact investments of their VC managers, but they sure can expand or constrain the scope of what a venture capitalist can do. Since venture capital is quite an unusual asset class, it tends to attract LPs with fairly unusual goals as well, which can include economic growth or simply societal improvement.

Reality #3: Venture Capital Performance is Pretty Much Opaque

The other major reason that venture capital funds don’t receive money from many sources is that the industry is notoriously hard to understand in terms of performance. Thus, LPs generally have to spend a great deal of time understanding the dynamics of different funds in order to identify the top performers.

This opacity of performance is simultaneously a function of the complexity of venture capital investments, as well as the lack of transparency of most managers in the industry about their results.

Venture capital is complex because money is not used until it is needed. When a fund is raised, there isn’t some big jackpot hiding on Sand Hill Road where all the funds are deposited. Instead, when an investment is made in a company, every LP has to wire their fair share of the amount as part of a “capital call.” Even though a particular LP may have committed $10 million to a fund, it will slowly disburse this money over a period of several years as the managers make investments.

Furthermore, venture capitalists rarely put a single check into a company. Instead, they often put in additional capital in later rounds (known as a pro-rata investment), which means that money will flow into a company multiple times. On the other side, exits are rarely clean as well, often requiring earnouts, or multiple share distributions as part of an acquisition. Due to the time value of money, it matters when dollars were called in and when they were returned to investors, yet such accounting can be difficult to track and assess (although anecdotally this has improved in the last few years).

When the data is compiled, the results don’t look good. The Kauffman Foundation famously found that very few venture capital funds in their sample produced a return above the public markets after accounting for fees. Given that venture returns tend to follow a power law, it seems only natural that the returns for the funds would also follow such a pattern.

Given these poor results, some observers believe that the lack of transparency in the industry partially explains why venture capital continues to attract limited partners, even when its aggregate performance is so low. I am less convinced about this, simply because plenty of firms do have track records of returning funds over extended periods of time. For those endowments and wealth managers that can get their dollars into the right funds, the returns speak for themselves. For everyone else, it certainly appears as though they are wasting their time and money.

The Reality of Venture Capital

Venture capital is very small, kind of weird, and doesn’t even perform that well. It’s a wonder why any country would want to build up this industry, and yet, governments around the world are putting in huge incentives to create VC industries in their nations. The main reason is the other side of results: the number of VC-backed companies that eventually IPO is significant, and who can argue with household names like Microsoft, Apple, or Google?

What then about Yo? I think the key message here is that different venture capitalists have different risk tolerances and desired areas of investment. It shouldn’t be surprising that after healthy returns from a number of social networking companies that investors are willing to put a bit of capital into a fresh startup that could one day make it big. And frankly, $1.2 million is a pittance of the more than $8 billion raised last year for the VC industry (note: the money likely came from angels and not funds, and thus is not even included in this amount). Investors build portfolios, not one-off dreams. Given the success of the app today in the App Store, maybe they were on to something in the first place.